Introduction
Compounding refers to the fact that you earn interest not only on the principal amount you invested, but also on the interest that is continually added to it. It implies that the interest accrued over the principal amount is not withdrawn and are added to the principal.Â
Power of Compounding
The Power of Compounding refers to the ability of the accumulated compound interest to serve as the additional capital in an investment. This simple but effective investing concept acts as a multiplier in your portfolio. The efficacy of compounding is such that the interest is accumulated over time and if it is allowed for a specific time, the reinvested amount itself is much more than the original investment. All you have to do is begin investing early, and compounding will grow your money for you over time.
Even though the interest accumulated over the principal, seem to be a modest sum, if you let the power of compounding to work its magic over time, it may make a significant impact in your investment.
How Compounding Works in Stock Market?
Compounding is fundamentally a long-term investing strategy. The approach involves two elements in order to function: revenue reinvestment and time. When you opt to reinvest the interest on a stock, your returns start to grow. As a result, you are efficiently converting your investments into a revenue commodity in which your money works for you to create profit. The “power of compounding” has the capability to increase rewards if invested in the right investments.
In stock market, compounding increases the returns in a dramatic way, and can very well be the defining difference between a mediocre underperforming stock and a high yielding long-term stock option. Despite your best efforts, your money will not expand much during the initial phase of wealth accumulation.
However, as the amount hits a tipping point, you will notice a significant difference. Once over this stage, both the principal and interest will expand significantly with each passing year, given that the interest is reinvested. It is also not a good idea to rush the process of compounding your riches.
The result can be explained with a simple example – Assume an investment of Rs. 1000 has been made in a certain stock. The stock rises 5% in the first year and thus the total amount grows to Rs. 1050. Now if you decide to hold on to the stock and in the subsequent year again there is a rise of 10%, which results in your invested amount rise to Rs. 1155. Here, compounding has been allowed on an amount of Rs. 1050 as opposed to the original investment of Rs. 1000.
How to Get Most Out of Compounding?
To get the most out of compounding and truly explore the power of compounding it is necessary to follow simple yet rigid rules:
- Starting early is one of the key principle. If you wish to enjoy the fruits of your wealth for it to ripe it will require a certain period, and if it is not started early the compounding may not affect the investment as much.
- Be disciplined with the investment, it could be tempting to withdraw a part of the interest however, the same may affect its growth altogether.
- Patience is the key with compounding, let the time take its toll and in turn deliver you with the best returns that could be ten folds.
Before you choose to hold on to a stock in hope to reap maximum returns out of it, it is necessary that you do a decent research about the stock in question, and be completely sure of the long term and constant growth. Along with the same, always keep an eye on the performance of the stock to sell them if the market crashes or for some reasons stock shows sign of not performing well.